Inventory Management

Ari Pranata Primisa Purba, S.T., M.T.

Ma’ruf, S.T.,M.Sc.
Defenition
oInventory is a stock or store of goods or services, kept for use or sale in the
future.
oInventory can be one of the most expensive assets of an organization. It may
account for more than ten percent of total revenue or total assets for some
organizations. Although companies in the manufacturing sector usually carry
more inventory than service firms, effective inventory management is
nonetheless important to both manufacturers and service organizations.
o Better management of corporate inventories can improve cashflow and return
of investment. However, the lack of comprehensive understanding of inventory
management techniques and trade offs often causes customer service levels to
drop. Developing effective inventory control systems to reduce waste and
stockouts in manufacturing or service organizations is a complex problem.
Inventory Investment Compared to Total Revenue and Total
Assets
o While the inventory to total assets
ratio for service organizations such
as casino hotels is relatively low
compared to most manufacturers,
inventory management for service
firms poses a different challenge.
o Casino hotels for example carry a
wide range of perishable food
items to stock the diverse
restaurants operating within their
properties. Managing perishable
inventory presents a unique
challenge to operations managers.
Categories Of Inventories
There are four broad categories of inventories:
oRaw materials; unprocessed purchased inputs or materials for manufacturing
the finished goods.
There are many reasons for keeping raw material inventories, including volume
purchases to create transportation economies or take advantage of quantity
discounts; stockpiling in anticipation of future price increases or to avoid a
potential short supply; or keeping safety stock to guard against supplier delivery
or quality problems.
oWork-in-process; describes materials that are partially processed but not yet
ready for sales. One reason to keep WIP inventories is to decouple processing
stages or to break the dependencies between work centers.
Categories Of Inventories
oFinished goods; completed products ready for shipment.
Finished goods inventories are often kept to buffer against unexpected
demand changes and in anticipation of production process downtime; to
ensure production economies when the setup cost is very high; or to stabilize
production rates, especially for seasonal products.
oMaintenance, repair and operating (MRO) supplies; materials and supplies
used when producing the products but are not parts of the products.
Solvents, cutting tools and lubricants for machines are examples of MRO
supplies. The two main reasons for storing MRO supplies are to gain
purchase economies and to avoid material shortages that may shut down
production.
The Motive for Inventory
There are some motives for holding inventory, similar to cash.
oTransaction motive: Economies of scale is achieved when the
number of set-ups are reduced or the number of transactions are
minimized.
oPrecautionary motive: hedge against uncertainty, including demand
uncertainty, supply uncertainty
oSpeculative motive: hedge against price increases in materials or
labor.
Important Issues in Inventory Management
1. Classifying inventory items
ABC Classification System
2. Keeping accurate inventory records
Inventory Record Accuracy & Cycle Counting
o Items are counted and records are updated on a periodic basis
o Often used with ABC analysis to determine the cycle (frequency of counting)
o Eliminates shutdowns and interruptions
o Maintains accurate inventory records
Cycle Counting Example
5,000 items in inventory, 500 A items, 1,750 B items, 2,750 C items
Policy is to count A items every month (20 working days), B items every quarter (60
days), and C items every six months (120 days)

Item Number of Items

Class Quantity Cycle Counting Policy Counted per Day
A 500 Each month 500/20 = 25/day
B 1,750 Each quarter 1,750/60 = 29/day
C 2,750 Every 6 months 2,750/120 = 23/day
Total 5000 77/day
Record Accuracy and Inventory Counting Systems
o Periodic Inventory Counting System
Physical count of items is made at periodic intervals (weekly,
monthly or yearly)
o Perpetual (continual) Inventory Counting System
Computer System that keeps track of removals from inventory
continuously, thus monitoring current levels of each item (Bar
code Technology)
Independent and Dependent Demand Inventory Management
Systems

o Independent demand - the demand for the item is

independent of the demand for any other item in inventory
o Dependent demand - the demand for the item is dependent
upon the demand for some other item in the inventory
 Independent Versus Dependent Demand
• Independent demand – finished goods, items that are ready to be sold such as
computers, cars.
• Forecasts are used to develop production and purchase schedules for
finished goods.
• Dependent demand – components of finished products (computers, cars) such
as chips, tires and engine
• Dependent demand inventory control techniques utilize material
requirements planning (MRP) logic to develop production and purchase
schedules.
 Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain. That is why it is forecasted.

Dependent demand is certain and it is calculated.

12
 Inventory Cost
Inventory costs can be categorized in many ways: as direct and indirect costs; fixed and variable costs;
and order (or setup) and holding (or carrying) costs.
o Direct Costs are those that are directly traceable to the unit produced, such as the amount of materials
and labor used to produce a unit of the finished good.
o Indirect Costs are those that cannot be traced directly to the unit produced and they are synonymous
with manufacturing overhead. Maintenance, repair and operating supplies; heating; lighting; buildings;
equipment; and plant security are examples of indirect costs.
o Fixed Costs are independent of the output quantity and Variable Costs change as a function of the
output level. Buildings, equipment, plant security, heating and lighting are examples of fixed costs,
whereas direct materials and labor costs are variable costs. A key focus of inventory management is to
control variable costs.
o Order costs are the direct variable costs associated with placing an order with the supplier, holding or
carrying costs are the costs incurred for holding inventory in storage. Order costs include managerial
and clerical costs for preparing the purchase, as well as other incidental expenses that can be traced
directly to the purchase. Examples of holding costs include handling charges, warehousing expenses,
insurance, pilferage, shrinkage, taxes and the cost of capital. In a manufacturing context, setup costs
are used in place of order costs to describe the costs associated with setting up machines and
equipment to produce a batch of product. In inventory management discussions, order costs and setup
costs are often used interchangeably.
Two fundamental issues underlie all inventory planning:
How Much to Order? & When to order?
 Inventory Model
Independent Demand Inventory Models to Answer These Questions
1. Single-Period Inventory Model:One time ordering decision such as selling t-
shirts at a football game, newspapers, fresh bakery products. Objective is to
balance the cost of running out of stock with the cost of overstocking. The
unsold items, however, may have some salvage values.
2. Multi-Period Inventory Models
• Fixed-Order Quantity Models: Each time a fixed amount of order is placed.
• Economic Order Quantity (EOQ) Model
• Production Order Quantity (POQ) Model
• Quantity Discount Models
• Fixed-Time Period Models:Orders are placed at specific time intervals.
EOQ Model
Important assumptions
1. Demand is known, constant, and independent
2. Lead time is known and constant
3. Receipt of inventory is instantaneous and complete
4. Quantity discounts are not possible
5. Only variable costs are ordering and holding
6. Stockouts can be completely avoided
Inventory Usage Over Time

Usage rate Average

Order quantity = inventory on
Q (maximum hand
Inventory level

inventory level)
Q
2

Minimum
inventory

0
Time

Total Time
The Inventory Cycle
Q Usage
Quantity rate
on hand
(maximum
İnventory)

Reorder
point
Time

Receive Place Receive Place Receive

order Place
order order order order
order

Lead time
 EOQ Model
o The economic order quantity can be derived easily from the total annual inventory cost formula using basic calculus.
o The total annual inventory cost is the sum of the annual purchase cost, the annual holding cost and the annual order
cost.
o Formula can be shown as:
TAIC = Annual purchase cost + Annual holding cost + Annual order cost
TAIC = APC + AHC + AOC
𝑄 𝐷
TAIC = (D×c) + ( 2 )×(h×c) + (𝑄) × S
where
TAIC = total annual inventory cost
APC = annual purchase cost
AHC= annual holding cost
AOC= annual order cost
D= annual requirement or demand
c= purchase cost per unit
S= cost of placing one order
h= holding rate; where annual holding cost per unit H=h×C
Q= order quantity
EOQ Model
o Since D, C, h and S are deterministic (i.e., assumed to be constant terms), Q is the only
unknown variable in the TAIC equation. The optimum Q (the EOQ) can be obtained by taking
the first derivative of TAIC with respect to Q and then setting it equal to zero.
dTAIC 1
= 0+( xh x c) + (-1 x D x S x 1/Q2 )
dQ 2
h𝑐 DS
= 2 - 𝑄2
dTAIC
Then setting equal to zero,
dQ
h𝑐 DS
- =0
2 𝑄2
h𝑐 DS
= = 2
2 𝑄
2 2DS
= 𝑄 = ℎ𝑐
2 𝐷𝑆 2 𝐷𝑆
EOQ = =
ℎ𝑐 𝐻
EOQ Model
Q = Order Quantity
Q*= Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

Annual setup cost = (Number of orders placed per year) x (Setup or order cost per order)

Annual demand Setup or order

=
Order Quantity cost per order

= D (S)
Q
EOQ Model
Q = Order Quantity
Q* = Optimal number of pieces per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year
Annual holding cost = (Average inventory level) x (Holding cost per unit per year)

= Order quantity (Holding cost per unit per year)

2

= Q (H)
2
What is the main insight from EOQ?
There is a tradeoff between holding costs and ordering costs
Total cost of holding
Annual cost and setup (order)

Holding costs
Minimum
total cost

Set up Or Ordering
Costs
Optimal Order
Quantity (Q*)

Order quantity
Example
Determine optimal number of needles to order (Q)
D = 4,000 units per year
S = $10 per order
H = $.50 per unit per year

2DS
Q* =
H

2(4,000)(10)
Q* = = 160,000 = 400 units
0.50
Example
Determine expected number orders per year (N)
D = 4,000 units Q* = 400 units
S = $10 per order
H = $.50 per unit per year
Expected Demand D
number of = N = =
orders Order quantity Q*

4,000
N= = 10 orders per year
400
Example
Determine expected time between orders (T)
D = 4,000 units Q* = 400 units
S = $10 per order N = 10 orders per year
H = $.50 per unit per year

Number of working
Expected days per year
time between = T =
orders N
250
T= = 25 days between orders
10
Example
Determine total annual cost:
D = 4,000 unit Q* = 400 units
S = $10 per order N = 5 orders per year
H = $.50 per unit per year T = 50 days

Total annual cost = Setup cost + Holding cost

D Q
TC = S + H
Q 2
4,000 400
TC = ($10)+ ($.50)
400 2
TC = (10)($10) + (200)($.50) = $100 + $100 = $200
Reorder Points
o EOQ answers the “how much” question
o The reorder point (ROP) tells when to order

Demand Lead time for a new

ROP = per day order in days
=dxL

d= D
Number of working days in a year
Reorder Point Curve

Q*
Inventory level (units)

Slope = units/day = d

ROP
(units)

Time (days)
Lead time = L
Example
Demand = 4,000 DVDs per year
250 working day year
Lead time for orders is 3 working days

D
d=
Number of working days in a year
= 8,000/250 = 32 units

ROP = d x L
= 32 units per day x 3 days = 96 units
If demand is known exactly, place an order when inventory equals
demand during lead time.

Order Q: When shall we order?

Quantity A: When inventory = ROP
Q
Q: How much shall we order?
Inventory A: Q = EOQ

Reorder
Point
(ROP)
ROP = LxD

Lead Time
Time
D: demand per period
Place Receive
L: Lead time in periods
order order
Production Order Quantity (POQ) Model

o The third assumption of EOQ model is relaxed: Receipt of inventory is not

instantaneous and complete
o Units are produced and used/or sold simultaneously
o Production is done in batches or lots
o Capacity to produce a part exceeds the part’s usage or demand rate
o Hence, inventory builds up over a period of time after an order is placed
Production Order Quantity Model

Part of inventory cycle during

which production (and usage) is
taking place
Inventory level

Demand part of cycle

with no production
Maximum
inventory

t Time

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Production Order Quantity Model
Q = Order Quantity p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Annual inventory = (Average inventory level) x Holding cost

holding cost per unit per year

Annual inventory = (Maximum inventory level)/2

level
Maximum = Total produced during the – Total used during the
inventory level production run production run
= pt – dt

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Production Order Quantity Model
Q = Order Quantity p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
t = Length of the production run in days

Maximum inventory = Total produced during the – Total used during the
level production run production run
= pt – dt

However, Q = total produced = pt ; thus t = Q/p

Maximum Q Q d
=p –d =Q 1–
inventory p p p
level

Maximum inventory level Q d

Holding cost = (H) = 1– H
2 2 p

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Production Order Quantity Model
Q = Order Quantity p = Daily production rate
H = Holding cost per unit per year d = Daily demand/usage rate
D = Annual demand

Setup cost = (D/Q)S

Holding cost = 1 HQ[1 - (d/p)]
2
1
(D/Q)S = 2 HQ[1 - (d/p)]

2DS
Q2 =
H[1 - (d/p)]

2DS
Q*p =
H[1 - (d/p)]

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Example

D = 1,000 units p = 8 units per day

S = $10 d = 4 units per day
H = $0.50 per unit per year days plant is open=250
2DS
Q* =
H[1 - (d/p)]

2(1,000)(10)
Q* = = 80,000
0.50[1 - (4/8)]
= 282.8 or 283
Production Order Quantity Model
Note:

d=4= D = 1,000
Number of days the plant is in operation 250

When annual data are used the equation becomes

2DS
Q* =
annual demand rate
H 1–
annual production rate

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Quantity Discount Models

o These models are used where the price of the item ordered varies
with the order size.
o Reduced prices are often available when larger quantities are ordered.
o The buyer must weigh the potential benefits of reduced purchase
price and fewer orders that will result from buying in large quantities
against the increase in carrying cost caused by higher average
inventories.
o Hence, there is trade-off is between reduced purchasing and ordering
cost and increased holding cost
 Total Costs with Purchasing Cost
Annual Annual
TC = carrying + ordering + Purchasing
cost
cost cost

Q + D S + PD
TC = H
2 Q

Where P is the unit price.

Remember that the basic EOQ model does not take into consideration the purchasing
cost. Because this model works under the assumption of no quantity discounts, price per
unit is the same for all order size. Note that including purchasing cost would merely
increase the total cost by the amount P times the demand (D). See the following graph.
Total Costs with Purchasing Cost
Cost

There are two general cases

Adding Purchasing cost TC with PD of quantity discount models:
doesn’t change EOQ
1.Carrying costs are
TC without constant (e.g. $2 per
PD unit).
2.Carrying costs are stated
PD
as a percentage of
purchase price (20%
of unit price)
0 EOQ Quantity
Total Cost with Constant Carrying Costs
In this case there is a
single minimum point;
all curves will have
TCa their minimum point at
Total Cost the same quantity
TCb
Decreasing
TCc Price

CC a,b,c

OC

EOQ Quantity
EOQ when carrying cost is constant
1. Compute the common minimum point by using the basic economic order
quantity model.
2. Only one of the unit prices will have the minimum point in its feasible
range since the ranges do not overlap. Identify that range:
a. if the feasible minimum point is on the lowest price range, that is the
optimal order quantity.
b. if the feasible minimum point is any other range, compute the total cost
for the minimum point and for the price breaks of all lower unit cost.
Compare the total costs; the quantity that yields the lowest cost is the
optimal order quantity.
Quantity Discount Model with Constant Carrying Cost
QUANTITY PRICE
S = $2,500
1 - 49 $1,400 H = $190 per computer
50 - 89 1,100 D = 200
90+ 900

2SD 2(2500)(200)
Qopt = = = 72.5 PCs
H 190

For Q = 72.5 SD H Qopt

TC = + 2 + PD = $233,784
Qopt

For Q = 90 SD HQ
TC = + 2 + PD = $194,105
Q
Total Cost with varying Carrying Costs
When carrying cost is expressed as a percentage of the unit price, each curve
will have different minimum point.
TCa
TCb
Cost

TCc

CCa
OC

CCb

CCc
Quantity
EOQ when carrying cost is a percentage of the unit price

1. Beginning with the lowest unit price, compute the minimum points for
each price range until you find a feasible minimum point (i.e., until a
minimum point falls in the quantity range of its price).
2. If the minimum point for the lowest unit price is feasible, it is the
optimal order quantity. If the minimum point is not feasible in the
lowest price range, compare the total cost at the price break for all
lower prices with the total cost of the feasible minimum point. The
quantity which yields the lowest total cost is the optimum
Quantity Discount Models
A typical quantity discount schedule, Demand 5000 units, Order Cost $49,
Inventory Carrying cost is 20% of unit price

Discount Discount
Number Discount Quantity Discount (%) Price (P)
1 0 to 999 no discount $5.00
2 1,000 to 1,999 4 $4.80

3 2,000 and over 5 $4.75

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When carrying costs are specified as a percentage of unit price, the total cost
curve is broken into different total cost curves for each discount range

Total cost curve for discount 2

Total cost
curve for
discount 1

Total cost $

Total cost curve for discount 3

b
a Q* for discount 2 is below the allowable range at point a and must
be adjusted upward to 1,000 units at point b

1st price 2nd price

break break

0 1,000 2,000
Order quantity
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Quantity Discount Example
Calculate Q* first for the lowest price range
2DS
Q* =
IP

2(5,000)(49)
Q3 * = = 718 cars/order
(.2)(4.75)

2(5,000)(49)
Q2* = = 714 cars/order
(.2)(4.80)

2(5,000)(49)
Q1 * = = 700 cars/order
(.2)(5.00)
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Quantity Discount Example 2DS
Q* =
IP
2(5,000)(49)
Q1* = = 700 cars/order
(.2)(5.00)

2(5,000)(49)
Q2 * = = 714 cars/order
(.2)(4.80) 1,000 — adjusted
2(5,000)(49)
Q3* = = 718 cars/order
(.2)(4.75) 2,000 — adjusted

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Quantity Discount Example

Annual Annual Annual

Discount Unit Order Product Ordering Holding
Number Price Quantity Cost Cost Cost Total
1 $5.00 700 $25,000 $350 $350 $25,700

2 $4.80 1,000 $24,000 $245 $480 $24,725

3 $4.75 2,000 $23.750 $122.50 $950 $24,822.50

Choose the price and quantity that gives the lowest total cost
Buy 1,000 units at $4.80 per unit

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Safety Stock

Quantity
Maximum probable demand
during lead time

Expected demand
during lead time

ROP

Safety stock
LT Time
Safety stock reduces risk of
stockout during lead time
Safety stock

• Because it costs money to hold safety stock, a manager must carefully

weigh the cost of carrying safety stock against the reduction in
stockout risk it provides.
• The customer service level increases as the risk of stockout decreases.
• The order cycle “service level” can be defined as the probability that
demand will not exceed supply during lead time. A service level of
95% implies a probability of 95% that demand will not exceed supply
during lead time.
Safety Stock

oThe “risk of stockout” is the complement of “service level”

Service level = 1 - Probability of stockout
oHigher service level means more safety stock
o More safety stock means higher ROP
o ROP = expected demand during lead time + safety stock (SS)
Reorder Point with a Safety Stock

Inventory level

Q
Reorder
point, R

Safety Stock
0
LT LT
Time
Probabilistic Models to Determine ROP and Safety Stock (When StockOut
Cost/ Unit is Known)
o Used when demand is not constant or certain
o Use safety stock to achieve a desired service level and avoid
stockouts

ROP = d x L + ss

Annual stockout costs = the sum of the units short x the probability x the stockout cost/unit
x the number of orders per year
Example
Giant Optical has determined that its ROP for eyeglasses frames is 50 (d x L)
units. Its carrying cost per frame per year is $5, and stockout (or lost sale)
cost is $40 per frame. The store has experienced the following probability
distribution for inventory demand during the lead time (reorder period). The
optimum number of orders per year is six. How much safety stock should
Giant keep on hand?
Number of Units Probability
30 .2
40 .2
ROP → 50 .3
60 .2
70 .1
1.0
Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

Number of Units Probability

30 .2
40 .2
ROP → 50 .3
60 .2
70 .1
1.0
Safety Stock Example
ROP = 50 units Stockout cost = $40 per frame
Orders per year = 6 Carrying cost = $5 per frame per year

Safety Additional Total

Stock Holding Cost Stockout Cost Cost
20 (20)($5) = $100 $0 $100

10 (10)($5) = $50 (10)(.1)($40)(6) = $240 $290

0 $0 (10)(.2)($40)(6) + (20)(.1)($40)(6) = $960 $960

A safety stock of 20 frames gives the lowest total cost

ROP = 50 + 20 = 70 frames
Probabilistic Models to Determine ROP and Safety Stock
(when the cost of stockouts cannot be determined)
Desired service levels are used to set safety stock

ROP = demand during lead time + ZsdLT

where Z = Number of standard deviations below (or above) the mean

sdLT = Standard deviation of demand during lead time
From non-standard normal to standard normal

oX is a normal random variable with mean μ, and standard deviation σ

oSet Z=(X–μ)/σ
Z=standard unit or z-score of X
Then Z has a standard normal distribution with mean 0 and standard
deviation of 1.
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© 2011 Pearson Education, Inc. publishing as
Prentice Hall
Probabilistic Example
Average demand = m = 350 kits
Standard deviation of demand during lead time = sdlt = 10 kits
5% stockout policy (service level = 95%)
for an area under the curve of 95%, the Z = 1.65

Safety stock = Zsdlt = 1.65(10) = 16.5 kits

Reorder point = expected demand during lead time + safety stock

= 350 kits + 16.5 kits of safety stock
= 366.5 or 367 kits
Probabilistic Demand

Minimum demand during lead time

Inventory level
Maximum demand during lead time
Mean demand during lead time
ROP = 350 + safety stock of 16.5 = 366.5
ROP → Normal distribution probability of
demand during lead time
Expected demand during lead time (350 kits)

Safety stock 16.5 units

0 Lead Time
time
Place Receive
order order
Probabilistic Demand

Probability of Risk of a stockout

no stockout (5% of area of
95% of the time normal curve)

Mean ROP = ? Quantity

demand
350
Safety
stock
0 z
Number of
standard deviations
Probabilistic Demand
Use prescribed service levels to set safety stock when the cost of stockouts cannot
be determined

ROP = demand during lead time + Zsdlt

where Z = number of standard deviations

sdlt = standard deviation of demand during lead time
Other Probabilistic Models to determine SS and ROP
When data on demand during lead time is not available, there are
other models available
1. When demand per day is variable and lead time (in days) is
constant
2. When lead time (in days) is variable and demand per day is
constant
3. When both demand per day and lead time (in days) are
variable
Other Probabilistic Models
Demand is variable and lead time is constant

ROP = (average daily demand x lead time in days) + Zsdlt

where sd = standard deviation of demand per day

sdlt = sd lead time
Probabilistic Example
Average daily demand (normally distributed) = 15
Standard deviation = 5
Lead time is constant at 2 days
90% service level desired
Z for 90% = 1.28

ROP = (15 units x 2 days) + Zsdlt

= 30 + 1.28(5)( 2)
= 30 + 8.96 = 38.96 ≈ 39
Safety stock is about 9 units
Other Probabilistic Models
Lead time is variable and demand is constant

Daily demand * Average lead time in days) +Z * (Daily demand) * slt

where slt = standard deviation of lead time in days

Probabilistic Example
Daily demand (constant) = 10
Average lead time = 6 days
Standard deviation of lead time = slt = 5 Z for 98% = 2.055
98% service level desired

ROP = (10 units x 6 days) + 2.055(10 units)(5)

= 60 + 102.75 = 162.75

Reorder point is about 163 units

Other Probabilistic Models
Both demand and lead time are variable

ROP = (average daily demand x average lead time) + Zsdlt

where sd = standard deviation of demand per day

slt = standard deviation of lead time in days
sdlt = (average lead time x sd2) + (average daily demand) 2slt2
Probabilistic Example
Average daily demand (normally distributed) = 150 Z for 95% = 1.65
Standard deviation = sd = 16
Average lead time 5 days (normally distributed)
Standard deviation = slt = 2 days
95% service level desired

ROP = (150 packs x 5 days) + 1.65sdlt

= (150 x 5) + 1.65 (5 days x 162) + (1502 x 12)
= 750 + 1.65(154) = 1,004 packs
Single-Period Inventory Model

Used to handle ordering of perishables (fresh fruits, flowers)

and other items with limited useful lives (newspapers, spare
parts for specialized equipment).
Single-Period Inventory Model
oIn a single-period model, items are received in the beginning of a
period and sold during the same period. The unsold items are not
carried over to the next period.
oThe unsold items may be a total waste, or sold at a reduced price, or
returned to the producer at some price less than the original purchase
price.
oThe revenue generated by the unsold items is called the salvage value.
Single Period Model
oOnly one order is placed for a product
oUnits have little or no value at the end of the sales period

Cs = Cost of shortage = Cost of understocking

= Sales price/unit – Cost/unit = lost profit
Co = Cost of overage = Cost of overstocking
= Cost/unit – Salvage value

Cs
Service level =
Cs + Co

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Single Period Example
Chris Ellis’s newsstand, just outside the Smithsonian subway station in
Washington DC, usually sells 120 copies of Washington Post each day.
Chris believes the sale of Post is normally distributed, with a standard
deviation of 15 papers. He pays 70 cents for each paper, which sells for
$1.25. The Post give him a 30-cent credit per unsold paper. He wants to
determine how many paper he should order each day and the stockout
risk for the quantity.

© 2011 Pearson Education, Inc. publishing as

Prentice Hall
Single Period
Average demand =  = 120 papers/day
Standard deviation = s = 15 papers
Cs = cost of shortage = $1.25 - $.70 = $.55
Co = cost of overage = $.70 - $.30 = $.40

Cs
Service level =
Cs + Co
Service
.55 level
= 57.8%
.55 + .40
.55
= = .578  = 120
.95
Optimal stocking level
© 2011 Pearson Education, Inc. publishing as
Prentice Hall
Single Period Example

For the area .578, Z  .20

The optimal stocking level
= 120 copies + (.20)(s)
= 120 + (.20)(15) = 120 + 3 = 123 papers
The stockout risk = 1 – service level
= 1 – .578 = .422 = 42.2%

© 2011 Pearson Education, Inc. publishing as

Prentice Hall
Fixed-Period (P) Systems
o Orders placed at the end of a fixed period
o Inventory counted only at end of period
o Order brings inventory up to target level
➢ Only relevant costs are ordering and holding
➢ Lead times are known and constant
➢ Items are independent from one another
Fixed-Period Systems
o Inventory is only counted at each review period
o May be scheduled at convenient times
o Appropriate in routine situations
o May result in stockouts between periods
o May require increased safety stock
Fixed-Period (P) Systems
Target maximum (T)

Q4
Q2
On-hand inventory
Q1 P
Q3

Time
Fixed-Period (P) Example
3 jackets are back ordered No jackets are in stock
It is time to place an order Target value = 50

Order amount (Q) = Target (T) - On-hand inventory - Earlier orders not yet
received + Back orders
Q = 50 - 0 - 0 + 3 = 53 jackets
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